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We recently caught up with the management of EXLService. Our takeaways: demand for BPO remains healthy, currency crosswinds should offset each other, and valuation remains compelling at current levels. On the demand front, there has not been a slowdown in BPO deal activity or an elongation of the sales cycle. Currency will create a headwind on the top line, but should be neutral to earnings. We look to the announcement of strategic deal signing as the next catalyst excluding any acquisition activity. We maintain our BUY rating.
- The demand environment for BPO remains healthy. There hasn't been a slowdown in deal flow especially at the smaller engagement level or elongation of sales cycles at the new or existing account level. The transformation business (14% of revenue) appears to be back on track after a slow start to the year in the first quarter (-7% y/y), which should be a tailwind to margins. The healthcare practice (5% to 10% of revenue) out of the Philippines remains a small but fast growing part of the business. There has not been an announcement of a strategic deal signing (3 in the pipeline), although conversations are progressing. A strategic deal signing announcement would be the next catalyst for the stock in our opinion. An announcement would be expected before the end of the third quarter, at the very latest, in order to have a positive impact on 2013.
- Model adjustment for rupee depreciation-revenue lowered, margins raised, EPS maintained. EXL has approximately 30% of its revenue base and approximately 60% of its workforce exposed to the rupee. Rupee depreciation has a negative impact on revenue, a positive impact on margins, and a negative impact on FX reported in other income. The net result is no impact to EPS. FY12 guidance provided on May 3 assumed a rupee exchange rate of 53 for May-December (8 months). Since early May, the rupee has depreciated to 56 (55 on average), 5.5% depreciation. Assuming an exchange rate of 56, the revenue impact would be a -1.1% (5.5%*30%*66%) for May-December, or about $5 mn. For FY12, we have lowered our revenue estimate to $442.3 mn from $447.3 mn, raised our adjusted operating margin to 16.7% from 15.9% (1% move has a 20 bp impact on operating margin over a full year), and raised our FX loss estimate to $6.7 mn from $3.6 mn. Our FY12 adjusted EPS estimate remains $1.53.
- Valuation. Our fair value is $33 based on a 22x adjusted P/E multiple and 11x adjusted EV/EBITDA multiple on our FY12 estimates. On an EV/non-GAAP EBITDA basis, EXL is trading at 6.6x, above WNS (WNS; BUY) at 4.4x but below Genpact (G; BUY) at 9.6x. Over the last four years, EXL's average forward P/E multiple is 22x ranging from 17x-30x on average annually and its average forward EV/EBITDA multiple is 9x ranging from 6x-13x on average annually. Valuation is particularly compelling at 10x 2013 estimates excluding cash for a potentially 20% earnings grower. The Indian BPO sector is nascent compared IT services. The sector has all the characteristics of a young group as the growth rates are exciting, but the margin profile is not yet as stimulating. The attrition rates are higher and there is sometimes friction among the client base.
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Joseph D. Foresi